Eric Peters - Paradigm Shifts and Solutions at One River (EP.422)

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2:31Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators .com. All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

3:11Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast. My guest on today's show is Eric Peters, who leads both OneRiver Asset Management and Coinbase Asset Management, and writes a widely dispersed blog called Weekend Notes, in which he shares macro insights. Eric's twice been a guest on the show, discussing his bespoke macro investment strategy four years ago, and case for Bitcoin three years ago. Both conversations are replayed in the feed. Since then, many of OneRiver's strategies played out well during COVID, and Coinbase acquired OneRiver digital asset management in March 2023.

3:54We got back together to discuss how Eric has adapted to the changing environment, including OneRiver's shift from bespoke offerings to a total portfolio solution and the continued case for Bitcoin. Along the way, Eric shares his keen insights on portfolio construction, left -tail risks, and right -tail opportunities. Before we get going, I was walking down the street and saw my friend Brian Furtado, the head of the family office practice at Apollo, on the other side of the street with a handful of shopping bags. Brian is a very affable, can -do type of guy. So as I crossed the street to say hello, I was surprised when he appeared frazzled and mumbling to himself.

4:40He looked up at me and repeated a phrase twice, just keep buying, just keep buying. Since that December 23rd, three years ago, just keep buying has become a mantra in our house during moments of holiday -induced stress. It's not really about retail therapy, although my wife Vanessa might mean it literally from time to time. It's about remembering that the sprint to the holidays can bring some stress, but the actions we take spread joy and cheer when the big day comes. So whether you're celebrating Christmas, the first day of Hanukkah, or anything else on December 25th, when you feel the inevitable pressure of the holidays, take a small action with the gift of giving in mind.

5:24Just keep buying. Thanks for spreading the holiday cheer with Capital Allocators. Please enjoy my conversation with Eric Peters. Eric, great to see you. Great to be back. Well, in the last couple of years, there's a lot that's changed in this entire environment. And I'd love to start with, how have you structurally addressed the changing environment? Boy, our business has gone through a lot of change. 2020 is the place to start. Prior to 2020, we were in this world of perceived secular stagnation and something was going to come along to propel us out of that. That was the rise of talk about MMT.

6:03And it made sense that whenever the next crisis hit, we would see a much different policy response from what we've seen in prior cycles. And then COVID hit. So prior to 2020, we had thought that inflation was going to pick up. I felt like we had the right strategy lineup for our clients. So we had trend following, We had long volatility. We had an inflation strategy that we're trying to get off the ground. We felt pretty well positioned for that going into for what we thought the next cycle would look like. And then that cycle hit, which was an incredible catalyst relative to anything I could have imagined.

6:37But all those themes started to play out. Big fiscal deficits, monetary debasement, inflation, and that provoked all sorts of changes in how we thought about our business and our solutions. So that was really the kickoff. What were some of those changes? For starters, we thankfully got through COVID with having delivered what we said we would deliver. So our longfall made a lot of money and we had weekly liquidity for our clients. We had huge redemptions through that, which was exciting because you want to deliver for your clients and you want to think that you can deliver weekly liquidity, but then you also have to have service providers strike a nav on every Friday in March and April.

7:11So the first part of it was that what we were doing worked. Then the question was, So what really happens from here? Because the catalyst for this new investment paradigm that we thought we had entered was so powerful that we thought correlations are going to be changed for a long period of time. So like the equity bond correlation could change. And that changes every institutional portfolio in terms of how it's going to perform, how to think about risk, where to seek opportunities. So we put a lot of thought into how do we help our clients more with what we have? And then we also entered crypto in November of 2020.

7:43And that was really to express one of those themes, which was monetary debasement and also captured some of the convexity of this new technology that was poorly understood at that time. What does OneRiver look like today? I am so excited about what we have going on right now. OneRiver is about a $3 billion business, and it's primarily focused on risk mitigation strategies. For the most part, our assets are in trend following and volatility strategies. We have a dispersion strategy as well, but the bulk of our assets are in systematic long equity vol and combinations of systematic long equity vol paired with trend following.

8:17Our total portfolio combines systematic long equity vol with trend following combined with equity beta. So I took the position when we started OneRiver, let's build a suite of different strategies that our clients can use either on a one -off basis or in combination to help tilt their portfolio, complete it, build various solutions that help their needs. And that's how we got to $3 billion. What we've never done is launch a flagship strategy. So a year and a quarter ago, I'd put the challenge out to the team. What do we have and what can we do that we think and that I would put all of my liquid capital into?

8:51If you could only do one thing, what would that be? And we did a lot of work around how to combine our strategies with equity beta. And that kicked off a series of three white papers that we've published, which in combination are the underpinning for this total portfolio. The result of it is if you combine equity beta in a leveraged way, like a portable alpha type return stacking way, with what we do at this firm, our strategies are negatively correlated, positively convex. So anytime there's a wobble in the market, what we do should make somewhere between okay money and really good money at a time when the S &P is drawing down.

9:29And then you can rebalance those physicians, which allows you to start compounding from a higher baseline. So the compounding effects are massive. So that's really one river. This will be the most important thing I do in my career from an investing standpoint. In terms of our contribution to investing, this is what our firm will in time be known for. You mentioned you wanted something where you'd put all your money in. How do you think about what are you trying to accomplish with the strategy? Trying to accomplish compounding at the highest possible rate with drawdowns that are sufficiently manageable that you won't lose your nerve.

10:00That's important for any investor. And we all have different pain thresholds. Mine happens to be high, by the way, but I wanted to build a strategy that was tempered. So ideally, the way we looked at it and the challenge that I had was, can we compound it higher than the S &P with lower drawdowns and a better sharp? And when I say mitigating the downside so that you don't lose your nerve, what I mean by that is everyone wants to outperform the S &P, the entire world. And if there are aliens, they probably want to add. outperform the S &P. The question is, what are you going to do in order to do that?

10:32And there are all sorts of portfolio combinations where people try to do various things. Some of them try to outperform the S &P and they end up oftentimes taking on a lot of additional risk that's quite correlated to underlying equities. It works great in the right market environment. And then when the market turns against those players, the losses that they suffer are such that they end up getting out at the worst possible time. They're either forced out or they choose to get out or their investment board says, why are we taking these risks? We didn't really understand it. So it's super important that whatever you build can survive adverse market environments.

11:07And what I tell the team all the time here, nothing good happens to dead people. It just doesn't. So the first and foremost, you have to figure out whatever you're doing, how do you make sure you survive it? That's really the objective. Because by the way, I don't know what equities are going to return on a forward looking basis. I suspect that it won't be as strong as looking back over the last 20 years. I suspect it'll be more volatile. There could be times where it's brilliantly positive as well. I think there are big right tails. There are also some really bad tails that are potentially out there.

11:34So I just wanted to make sure that we had something that was robust to any range of market environments that you wouldn't get squeezed out of the position and that could ideally compound at better than equity and be liquid. When you start looking at the pieces that brought this together, you mentioned the S &P as the equity beta. How do you think about the S &P versus some other form of equity beta as the driver of that growth engine? The strategy has three different equity betas for people. So one is the S &P 500, another is the NASDAQ 100, and then MSCI world. That covers most of it. What I wanted to see when we did our analysis, this framework, what would it look like if we had some really lousy equity beta in there instead?

12:13We try to find the worst stock markets in the world that are credible stock markets. Eurostox 50 and Hang saying, those are the two really worst stock markets in the world from a performance standpoint over the last 17, 20 years. And if you create this portfolio combination with the rebalancing structure that we have put in place, you achieve multiple times, even with a lousy underlying equity market. If you really want to be an investor and make money, you got to invest in equity. You got to invest in the underlying growth of the economy. So I don't know what the future holds in terms of what are equities going to deliver, hopefully a lot in real terms, probably quite a bit in nominal terms, given what I think will happen.

12:52But I don't really know. The key is to have that construct that you think will outperform. So we get into the more interesting stuff on top of it. You mentioned that you're putting systematic strategies and not discretionary. In the past, you've done both. Why did you come to wanting to do this with systematic strategies? I've been a discretionary trader investor my whole career. And when I launched OneRiver in 2013, I tried to think of things in 10 -year increments. So I really thought about what we wanted to build. What I concluded was that if we didn't embed technology within our firm, we would be unlikely to have a firm in five or 10 years.

13:28That was a pretty simple statement, high conviction. Just because if you look at technology trends in every aspect of society, you want to be long innovation. And I thought without that, then I don't know, maybe I'm just reminiscent of the stock operator. Nothing's really changed for how discretionary investment decisions are being made. The upside is as a discretionary investor, you can potentially see things around the corner that have never happened before, haven't happened in such a long period of time that your quantitative strategies can't foresee it. So that's the advantage. The downside is you have a human making decisions and you have a lot of emotion involved.

14:01So I thought that if we could embed provide discretionary investing principles that I and the team have learned over time into strategies that are fully codified. And we could take out the emotion from investing, build really well risk -managed quantitative strategies so that if we were wrong and there was something that had never happened before, we'd have something to get us out. But that was the bet that I made in 2013 with the firm. And as it turns out, the vast majority of our assets under management are in quantitative strategies. One of the advantages you have there is if you come up with the right investing principles, you can apply them across a lot of different markets and typically do them in instruments that are quite cash efficient.

14:42So they're pretty scalable and they combine well into solutions for our clients. And the other advantage of quant strategies is that when you sit across the table from a very large allocator who's comfortable with quantitative strategies, you can look at how the logic embedded within that strategy would have done in a variety of different periods without having to guess what someone's discretionary decision would be. And I think that's actually really valuable, particularly as you combine strategies. So I've gravitated very strongly in that direction. There will always be things that OneRiver does on a discretionary basis.

15:17Moving to crypto was incredibly profitable and that was discretionary. And it was working with one of our biggest clients who's a brilliant investor. And we'll do things like that in the future, but there'll be fewer and further between, I think. So within this strategy, there's the long vol piece and there's the trend piece. On the long vol component, what are you putting into this new aggregated strategy? So the long vol component we've been running since 2015, it's called dynamic convexity, and it's well -named in the sense that it's a highly convex strategy. It trades in VIX futures, options on VIX futures, V -stocks futures, which is the VIX equivalent in Europe, and a whole host of different straddles on global equity indices.

16:00So there are a number of legs to the stool, so to say, and we continue to do research and put new interesting things in there. And it's very capital efficient, which is why we can build it into this total portfolio. When we combine our dynamic convexity and our trend following strategies into one strategy, It's called risk responders. We use, roughly speaking, in a benign market, 23 % of the cash for margin. And in a stressed environment, that might go up to 50. So we have all this extra cash, which allows us to marry that with equity beta using futures so that we have in the total portfolio in a normal market environment, 31 cents of every dollar is invested in futures.

16:42The rest is in cash earning T -bills. Having those components that are really capital efficient, they work well together. What is it that makes it more capital efficient than another comparable strategy? There are all sorts of different strategies that people use to try to attempt to be long fall. We have a very purist approach. And when I'm purist, I mean, we only ever are long fall. We never are short fall. And the reason for that is over my career, which is now 35 years, at every cycle, I have seen people who have convinced themselves they're long fall on a net basis because they're long vol somewhere and they're short a little bit somewhere else because they don't think it's really going to hurt them.

17:20And then there's some unique aspect to this latest crisis and then they either don't perform or they really underperform or in some cases, they lose everything. So we come at it with the appropriate amount of humility, which is to say, look, we understand these markets really well, but we don't know what the future holds. So we're not going to be short vol anywhere. In our case, not much is going on. We have extremely low capital usage, we could have as little as 5 % of capital that we're using in a really quiet market, but it's very dynamic. So that can ramp up in a crisis like COVID. It could ramp up to 30, 40, 45%.

17:57When you think about combining solutions like this into something like total portfolio, cash efficiency is vital. Without it, you can't do it. When you've traded across all different markets, why do you choose equities and not some mix of all different assets? The real use for dynamic convexity is to help our clients reliably lean something up against the biggest risk in their book. We work with pensions, endowments, sovereigns. If you look at the real risk in their portfolio, it's probably 90 % driven by equities. And it comes in all sorts of different forms, private equity, public equity, credit.

18:32You end up with portfolios that there's just one risk factor, which is equities. So having a strategy that was highly convex to, let's say a move in oil or gold or something like that, it might work for those investors, but it might not work at all. So that's the biggest reason, but there are also liquidity reasons. The VIX market is an incredibly deep liquid market. So we can move through that market without having a footprint and that's a great thing. In this risk responder strategy, which trend strategies are you pairing with the long equity ball? So we run two trend strategies. One is on what we call core markets and the classic funds that we also offer an alternative market trend strategy, which is 110 markets.

19:16There's a little bit of overlap. So roughly speaking, I think we have 153 markets, 154 markets that we trade across those trend -following strategies. And we've tried to find markets that are as lowly correlated as possible. So how do these three components, the equity beta long vol and trend work together such that you took equity beta and as you looked at it historically, this outperforms? What we do is we take, say, $100 of equities, we replace that with futures contract, and we actually put in $110 of equity exposure. Explain that in a second. So that probably takes $7 of margin to do that.

19:53So now we've got 93 bucks left. And then we layer in the risk responders program, which is $23 out of every 100. And we put 100 % of that risk responders, which is dynamic convexity and trend falling in there. In a benign market, we call benign market that's drifting or trending upwards, we're going to expect in dynamic convexity to lose two to 5 % a year. So having 110 % equity beta basically just looks at that strategy and says, well, if the market drifts up, there's going to be some drag because you're long this dynamic convexity, you're long your hedge essentially, and that hedge is going to cost you.

20:26So if you combine those two things, you should still end up with 100 % of the equity performance on the upside. And then you look at trend following and you go, okay, over the long haul, let's say trend is going to deliver a plus 0 .2345 sharp, something like that. But for the purpose of this portfolio construction, just imagine it does nothing in a year. So now what happens in a strong S &P year? Well, your S &P goes up, let's say 15%. You invested $100, it's now worth 115. What you can do is take your risk responders portfolio and just size it up to that new overall 115 level. So now you start compounding again off of the 115 base, but you've got more protection on because you've been able to upsize it because the whole portfolio is a derivative portfolio.

21:11Now imagine that next year, the S &P is down 20 % or you have a COVID or you have a GFC. Well, you are highly likely to make a lot of money in your risk responders program, and your S &P is going to be 20 % or 30 % or 40 % down. So now what you're doing is you're looking at that overall portfolio level. It's going to actually be higher than 115, even though equities are deeply discounted, but you're rotating money back into the S &P. When that market correction or bear market ends, you're now compounding from a much higher base than if you just owned equities the whole time. How do you think about the optimal rebalancing strategy?

21:50The team did a lot of work on this and they looked at countless simulations of different rebalancing schedules and they looked at calendar -based reschedules. They looked at threshold -based. So if my hedge is up 10 % or 50 or 30 or whatever it might be, we rebalance half of it or all of it because that's often what investors do. The conclusion from that was actually the optimal approach is pretty simple, actually. Somewhere around a month is a pretty good place to be. If you choose thresholds, sometimes if you choose the exact right threshold, it's great because there's no give back. But if Ristis Run was only up 27 % or 29 % and you didn't at that threshold and it came back against you, you'd have a poor outcome.

22:33So what you find is there's a lot of variance in the threshold based. Now, what was funny is we were in Australia speaking with a big client and we said, well, here's the work. So what do you think? And they're like we're definitely going to continue to do threshold. And we're like, why? That's fine. But the research says otherwise. They're like, because there's the investment port effect. If our portfolio is under a ton of stress and we have some type of hedge that's up 30 or 40 or 50 percent and we walk into the boardroom, they're going to say, take it off. So we ran simulations looking at combinations of threshold based and calendar based.

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24:38completely understand why. But if you have, in a way, if you can make the choice to do it in a dispassionate way, over time, you're going to do better. When does the package suffer the most? The package suffers the most when trend is underperforming and vol doesn't really kick in and equity markets are performing poorly. Because if equity markets are performing well, then you could say, well, we're underperforming the S &P. Okay. We have a strategy that should outperform the S &P substantially through time, but that doesn't mean it always will. So I don't view that as being a real negative. So the question is, can you have a period where the S &P goes down?